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Sunday, February 6, 2011

The Case Against the Mortgage Interest Deduction

As the US economy struggles to recover from recession and cope with a budget crisis, all past policies must be put on the table for review and revision. Even the sacred cows. Even the mortgage interest deduction.

A new report from the OECD, which deserves more attention than it has been getting, explains the role badly-designed housing policies played in triggering the recent economic crisis. As the report shows, housing policy varies greatly among developed economies. There are some areas where the United States scores well. For example, it has a relatively liberal regime of building and land use permits. As a result, the supply of housing responds more to rising prices than in other OECD countries. Also, with the exception of some urban areas like New York and San Francisco, the US rental housing market has a healthier balance between the rights of landlords and tenants. However, in the area of tax treatment of owner-occupied housing, the United States comes off poorly.

From an economic perspective, the goal should be equal tax treatment of housing and other forms of investment. Unequal tax treatment of housing encourages speculative behavior, increases price volatility, and crowds out more productive forms of investment, all to the detriment of growth and macroeconomic stability.

In principle, there would be two ways to level the playing field. One would be to tax the imputed rental value of owner-occupied housing (that is, the rent it would bring if put on the market), while allowing interest costs to be deducted as an expense, just as interest is deductible and rental income taxable for owners of rental housing. The alternative would be to tax mortgage interest but leave the imputed rental value of owner-occupied housing untaxed.

On purely theoretical grounds, the better approach would be that of taxing imputed rents while allowing deductions for interest and depreciation. However, this approach is hard to implement and has rarely been used. A survey of international housing tax policy notes that Sweden taxed imputed rents until 1991 and the UK until 1963, but that both countries have since abandoned the system. Italy still taxes imputed rents, but the marginal rate is lower than for other forms of income, and the tax basis is thought to understate actual rental values. Many countries, including the United States, have property taxes that vary according to value, but these are considered to be imperfect substitutes for taxes on imputed rents. Among other reasons, they are believed to seriously understate both the market value and imputed rents of housing.

The alternative would be to forgo both taxation of imputed rents and deductibility of mortgage interest. Several countries take that approach, including Australia, Canada, Germany, and Japan. Such a system does not level the playing field as well as a fully implemented system of taxing imputed rents, but is far more practical from an administrative point of view.

Other tax policies can also affect the relative attractiveness of housing investment, including tax treatment of capital gains on housing and deductibility of local property taxes against national income taxes. One way to capture the total impact of the tax system on returns to housing investment is to look at the gap between market interest rates and the after-tax debt financing costs for housing. The greater the gap, the greater the pro-housing bias of the tax system. The following chart from the OECD report shows that the gap for the United States, while not the largest of all member countries, is considerable.

Aside from its effects on growth and economic stability, the mortgage interest deduction is open to criticism on distributional grounds. For reasons detailed in a recent study from the Urban Institute-Brookings Tax Policy Center, the great bulk of the benefits go to higher-income households. First, because it is a tax deduction, not a tax credit, mortgage interest relief benefits only those who itemize deductions on their personal income tax returns. Some 98 percent of tax units with incomes over $125,000 itemize, compared with just 23 percent with incomes of $40,000 or less.Second, because there is no cap on the deduction, owners of more expensive homes gain more than those with more modest homes. Third, a dollar of tax deduction is worth more to households in higher tax brackets than to those in lower tax brackets.

The Tax Policy Center study concludes that the mortgage interest deduction is worth $5,393 a year for tax units in the top 1 percent of the income distribution (average income $1,302,188) but only $215 per year to those in the middle 20 percent (average income $43,678). For households in the bottom 20 percent of the income distribution, the deduction has almost no value.

The final element of the case against the mortgage interest deduction is the potential contribution its elimination would make to resolving the US budget crisis. As I have argued in a previous post, tax reform that lowers marginal rates while broadening the tax base is by far the most growth-friendly path to fiscal consolidation. The Tax Policy Center study estimates that elimination would increase federal revenues by $108 billion in 2012, rising to $162 billion in 2019. Taking into account the likelihood that people would sell interest-earning assets to pay down mortgages would reduce the revenue figures slightly, to $91 billion in 2012 and 138 in 2019. By comparison, it would take a 15% across-the-board cut in non-defense discretionary spending to achieve the same deficit reduction.

On the other side, the principal argument in favor of the mortgage interest deduction is the claim that home ownership would otherwise be unaffordable for a large segment of the population. For two reasons, that argument does not hold water.

First, as explained above, the mortgage interest deduction has little value for lower- and middle-income families, those most likely to be on the borderline between rental and ownership. A subsidy worth $215 a year is not going to move many $40,000 families out of rental housing into a home of their own. Neither would a tax increase of $5,000 a year be likely to induce many millionaires to move out of their own homes into rentals.

Second, the impact on the affordability of housing is reduced to the extent that the interest deduction is capitalized into the market value of homes. Greater tax benefits cause buyers to bid up home prices. Conversely, elimination of those benefits would make home ownership less attractive, so home prices would fall. Capitalization of tax benefits does not fully offset the impact on home ownership because higher prices also encourage construction of new homes, but the effect is substantial.

The above discussion is framed in the context of immediate and full repeal of the mortgage interest deduction. Some would argue that such a cold-turkey approach is politically infeasible and would be too disruptive to the housing industry and family finance. For those who prefer a more gradual approach, at the cost of a more modest contribution to fiscal consolidation, there are many well-developed proposals for partial or phased repeal. One idea would be to switch from a deduction to a tax credit, which would be worth more to low-income families. At the same time, the value of the deduction to upper-income families could be capped in one way or another. Either of the above ideas could be phased in gradually over time, and structured to make a larger or smaller contribution to deficit reduction.

Will any of it happen? Some people think not. There is a widespread, although poorly substantiated, belief that home ownership makes people better citizens. (Skeptics think it is just as likely that the causation runs the other way, with responsible, hard-working citizens being more likely to own homes.) There is a more strongly substantiated tendency for wealthy individuals, who receive the bulk of the benefits of the interest deduction, to exercise disproportionate political influence through higher voting rates and bigger campaign contributions. For both reasons, the mortgage interest deduction is truly a sacred cow of American politics. It is a cow that should be led to slaughter.

Follow this link to download a brief slideshow with additional charts and data concerning the mortgage interest deduction.

3 comments:

Nice article Ed. Couldn't we ameliorate the effects without totally removeing the mortgage interest deduction. Suppose we disqualified 2nd home mortgage interest and reduce the qualified indebtedness cap from $1,000,000 to say, $300,000 so the middle class can get a break if they can itemize.

I'm with you though; we have seen what speculation volatility has done to foster insane expectations about Real Estate Values (or is it the other way around?).

John-- Your suggestions would help some, although if the aim is to focus benefits on the middle class, converting the deduction to a credit would work even better. However, that leaves open the question of when it is good policy for government to bestow benefits on the middle class. An alternative view would be to tax the rich (but as little as possible), focus benefits on the poor, and leave the middle class to fend for themselves in a market with fewer total taxes and subsidies than we have now.

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